Five Years After Dodd-Frank: Unintended Consequences and Room for Improvement

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Five Years after Dodd-Frank: Unintended Consequences and Room for Improvement

David A. Skeel University of Pennsylvania Law School, [email protected]

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Recommended Citation Skeel, David A., "Five Years after Dodd-Frank: Unintended Consequences and Room for Improvement" (2015). Wharton Public Policy Initiative Issue Briefs. 11. https://repository.upenn.edu/pennwhartonppi/11

This paper is posted at ScholarlyCommons. https://repository.upenn.edu/pennwhartonppi/11 For more information, please contact [email protected]. Five Years after Dodd-Frank: Unintended Consequences and Room for Improvement

Summary This brief offers a 5-year retrospective on Dodd-Frank, pointing out aspects of the legislation that would benefit from correction or amendment. Dodd-Frank has yielded several key surprises—in particular, the problematic extent to which the Federal Reserve has become the primary regulator of the financial industry. The author offers several recommendations including: clarification of the rules yb which strategically important financial institutions (SIFIs) are identified; overhauling the incentives offered to banks; instituting bankruptcy reforms that would discourage government bailouts; and easing regulatory burdens on smaller banks that are disproportionately burdened by the SIFI designation process.

Keywords Dodd-Frank, Federal Reserve, financial eform,r banks

Disciplines Economic Policy | Public Policy

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This brief is available at ScholarlyCommons: https://repository.upenn.edu/pennwhartonppi/11 publicpolicy.wharton.upenn.edu Five Years after Dodd-Frank: ISSUE BRIEF VOLUME 3 Unintended Consequences and NUMBER 10 Room for Improvement DECEMBER 2015

David Arthur Skeel, JD

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), signed into law on July 21, 2010, was a sprawling, imperfect, 2300-plus page response to the worst financial crisis in the U.S. since the Great Depression.

It likely will be the only major financial reform legislation for the next generation, so it warrants regular ret- SUMMARY rospectives. Marking the law’s significant anniversaries • This brief offers a 5-year retrospective on Dodd-Frank, pointing gives policymakers an opportunity to evaluate areas for out aspects of the legislation that would benefit from correction correction and amendment. or amendment. SURPRISES AND UNINTENDED • Dodd-Frank has yielded several key surprises—in particular, the extent to which the Federal Reserve has become the primary CONSEQUENCES IN THE FIRST FIVE YEARS regulator of the financial industry. This reflects a problem, namely that the regulatory framework established by Dodd- Five years after passage, many of Dodd-Frank’s rules Frank violates the requirements of the rule of law. It relies too remain unwritten and some still await proposal, which is heavily on regulatory discretion, is insulated from effective oversight, and eschews transparency. not surprising given the number of issues and agencies involved in writing and implementation. As of the fifth • In light of Dodd-Frank’s departures from rule of law, the legisla- anniversary in July, only 63% of rules had been finalized, tion could be improved in several ways: by clarifying the rules while about 20% had missed deadlines, the majority of by which regulators designate entities as strategically important financial institutions (SIFIs) and require their creation of living which concern derivatives and mortgage reforms (Figure 1 wills; providing better incentives for banks to downsize more 1). What is surprising, however, is that there is still efficiently; curbing incentives for banks to shift key operations so much regulatory pressure on systemically important to the shadow banking system; instituting bankruptcy reforms financial institutions (SIFIs), particularly big banks. that would discourage government bailouts; and easing regu- Many insiders expected from the outset that banks latory burdens on smaller banks that are disproportionately would be inducing regulatory rollbacks by now, but that burdened by the SIFI designation process. 2 has not happened. There are many reasons why regulators’ policing efforts remain aggressive and why the U.S. is not moving publicpolicy.wharton.upenn.edu

in a less regulatory direction after five the case of bonds and is leading to increased scrutiny into banks with years, but three causes stand out. The liquidity issues in the bond market global trading operations at a time first is the London Whale incident because banks have cut back on per- when U.S. agencies were in the midst of 2012, which single-handedly missible and borderline bond trading of Dodd-Frank rulemaking. accounted for the severity of the as they have shed their proprietary The third explanation for the Volcker Rule. The London Whale, a trading businesses. As more and more current regulatory climate is Sena- nickname given to JPMorgan trader activity moves into the shadow bank- tor Elizabeth Warren (D-MA). The Bruno Iksil, whose job entailed trading system, proprietary trading could election of Warren to the Senate was ing for his firm’s own account (i.e., become less regulated (and more an unintended consequence of critics’ proprietary trading), developed an elaborately disguised), defeating the successful derailment of her nomi- excessively large position in the credit initial intentions of the Volcker Rule. nation to head the new Consumer default swap market that had to be The second spur for the surpris- Financial Protection Bureau (CFPB), written down as a loss. When the dust ingly aggressive Dodd-Frank rule- which was inspired by Warren’s own settled, the activities of this one trader making is the LIBOR scandal, a research as a Harvard professor. If 3 caused a $6.2 billion loss for his firm. story that broke on the heels of the Warren had been approved as the first This type of high-capacity, high-risk London Whale. Several British and CFPB head, she wouldn’t have run for trading within commercial banking international news agencies exposed the Senate. Since joining Congress in and lending institutions like JPMor- widespread, fraudulent manipulation 2013, Warren has deftly utilized her gan is what the Volcker Rule seeks of LIBOR rates in trades between big new platform and committee posi- to eliminate by limiting proprietary banks, which colluded for over two tions, particularly her role in the Sen- trading and separating it from a bank’s decades to boost appearances of cred- ate Committee on Banking, Housing, normal, market-making and client- itworthiness and to increase profits and Urban Affairs, to champion tough based activities. How the rule will from this rate rigging. U.S. deriva- financial regulation and consumer 4 work in practice is not so clear cut. tives—a several hundred trillion dollar protection among her colleagues and An unintended consequence of market—and other financial products in the media. The CFPB, which she Dodd-Frank is that the Volcker Rule benchmark their interest rates on also helped to implement as an advi- already has pushed several critical LIBOR, so this manipulation affected sor to the President, has been a valu- banking functions into the shadow markets and consumers around the able and necessary innovation, but the banking system and it likely will con- world, but especially in the U.S. The Bureau does have a designated source 5 tinue to do so. Big banks appear to British government gained oversight of funding and a centralized structure, be retrenching on some of the opera- of LIBOR after much investigation, which makes overturning any of their tions the law permits them to engage and new regulations soon passed the decisions difficult. The CFPB will in, such as market-making and trading U.K. Parliament. In the U.S., this inci- need to avoid mission creep in the for clients. This is especially true in dent and the London Whale scandal long-run to avoid becoming another

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1 http://graphics.wsj.com/dodd-frank-anniversary/. bank financial intermediaries that perform many of the among other types of non-financial entities. 2 One major exception is the so-called “swaps pushout” rule. same functions commercial banks do, but without oversight. 7 For more information, see Susan Wachter, “Next Steps in This would have required banks to move their derivatives Shadow banks raise funds to buy assets, but they have no the Housing Finance Reform Saga,” Penn Wharton Public trading out of their commercial bank subsidiaries, but was deposit insurance and no recourse to the Federal Reserve Policy Initiative Issue Brief, March 2015: http://publicpolicy. repealed as part of budget legislation. in a crisis. Examples include hedge funds, money market wharton.upenn.edu/issue-brief/v3n2.php. 3 http://www.bloomberg.com/news/articles/2015-05-21/ mutual funds, structured investment vehicles, and many 8 For more information on bank stress-tests, see Itay Gold- jpmorgan-directors-don-t-have-to-face-london-whale-loss- other types of entities. (For more, see: http://www.imf.org/ stein, “Disclosure of Bank Stress-Test Results,” Penn Whar- claims. external/pubs/ft/fandd/2013/06/basics.htm). ton Public Policy Initiative Issue Brief, June 2013: http:// 4 The Volcker Rule did not take effect until July 2015. 6 This concern has merit, given recent loan regulations issued publicpolicy.wharton.upenn.edu/issue-brief/v1n6.php. 5 The shadow banking system refers to the entirety of non- by the CFPB affecting auto dealers and for-profit colleges, 9 The Fed recently released its proposed rule implementing

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FIGURE 1: FIVE YEARS LATER: DODD-FRANK RULEMAKING PROGRESS (JULY 2015)

Finalized Banking Regulations 40 3 1 Missed Deadline, Proposed Consumer Protection 31 1 2 29 Missed Deadline, Not Proposed Future Deadline, Proposed Derivatives 53 30 4 Future Deadline, Not Proposed

Mortgage Reforms 29 4 16

Orderly Liquidation Authority 7 2 7

Systemic Risk 13 4 5 6

Other 56 8 3 3 4

Source: DavisPolk, “Dodd-Frank Progress Report,” July 16, 2015. negative, unintended consequence of halts any significant housing finance EVALUATING DODD-FRANK 6 7 Dodd-Frank. reform measures going forward. UNDER THE RULE OF LAW Another striking development The final major surprise over the (or lack thereof ) in the last five years last five years is the extent to which The rule of law, according to the is lawmakers’ failure to reform Fan- the Federal Reserve has become the Resolution of the Council of the nie Mae and Freddie Mac since the primary regulator of the financial International Bar Association (2005), federal government placed them in industry via both Dodd-Frank and “establishes a transparent process conservatorship in 2008. The U.S. non-Dodd-Frank stress-tests, as well accessible and equal to all. It ensures 8 Treasury has been collecting all profits as living wills (see below). Dodd- adherences to principles that both from these entities since Fannie and Frank did limit the emergency power liberate and protect.” In the context Freddie began making them again of the Fed by prohibiting it from of financial regulation, the rule of in 2012, so in that sense the lack of making emergency loans to individual law requires that any intervention reform and restructuring is not shock- institutions in an attempt to discour- by regulators be governed by legal ing. But because these institutions age future bailouts akin to those made rules and not merely by discretion- 9 were key factors in the financial crisis, in 2008. But the Fed’s enforcement ary choice. In matters of discretion, their exclusion from new legislation of capital and liquidity standards now policy must be decided by those who was odd five years ago and the con- appears to be the most important reg- write the rules and not by those who tinual absence of Fannie and Freddie ulatory development of Dodd-Frank, enforce them. The rule of law, there- reform is no less curious. Their limbo and this is one of several “rule of law” fore, requires legal provisions to be status in conservatorship effectively concerns to which we now turn. specific. Furthermore, in the instance

NOTES

this restriction. 1407270607?alg=y. of the failed holding company. In recent months, the banks 10 David Skeel, The New Financial Deal: Understanding the 13 Single point of entry (SPOE), to oversimplify, entails taking have suggested they would shed assets in connection with Dodd-Frank Act and Its (Unintended) Consequences (Hobo- over a holding company, establishing a bridge institution, the recapitalization, which looks somewhat more like a ken, NJ, 2011). and transferring all secured debt and short-term liabilities liquidation than previous versions of the SPOE strategy. 11 In its short life, the FSOC already has considered designat- of the holding company to the bridge institution, as well 14 http://www.bloomberg.com/news/articles/2014-03-20/ ing as SIFIs such entities as mutual funds and hedge funds, as all licenses and other assets. Company stock and bond volcker-rule-will-cost-banks-up-to-4-3-billion-occ-says. whose catastrophic impact upon theoretical failure is clearly debt would remain with the holding company. The old stock 15 The one day stay on derivatives does not apply to derivatives debatable. would likely be canceled, and the bondholders would receive traded outside the U.S., and the largest banks have many 12 http://www.wsj.com/articles/fed-fdic-rebuke-bank- stock in the new bridge institution in place of their debt. The subsidiaries overseas that engage in this activity. This ap- ruptcy-plans-of-11-of-nations-biggest-banks- new bridge institution would thus be a recapitalized version pears to be part of the reason that the Fed failed the 11 liv-

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of a violation or a regulatory interven- There are four important com- from competition. tion, the affected person or institution ponents of Dodd-Frank that violate The second rule of law concern is must have recourse to their right of the rule of law. The first is a feature another feature of Title I that requires due process. The regulatory frame- of Title I, which gives regulators institutions designated as SIFIs to work established by Dodd-Frank vio- the authority to designate financial prepare a rapid resolution plan each lates all of these rule of law require- institutions as systemically important. year, often referred to as a living will. ments. It relies heavily on regulatory Bank holding companies that have Living wills are plans for how an discretion, is insulated from effective more than $50 billion in assets are institution would pursue an orderly oversight, and eschews transparency. automatically deemed to be SIFIs bankruptcy in such a way as to mini- Operating under the assumption and, as of late 2015, regulators from mize systemic damage. These plans that giant financial institutions are the new Financial Stability Over- are valuable and a welcome inclusion inevitable and that the federal gov- sight Council (FSOC) have desig- in Dodd-Frank because they can be ernment should simply make sure it nated as systemically important four used to simplify the structures of has the tools to control them, Dodd- other institutions: AIG, Prudential, large financial institutions for regu- Frank foments a partnership between GE Capital, and Metropolitan Life lators, but in practice their use has the government and the largest banks (although MetLife is contesting its been far from transparent. The Fed which began during the financial SIFI status in court). Not only is this and the FDIC have complete discre- crisis when regulators rescued Bear designation process overinclusive for tion to accept or reject a living will Stearns—one of the nation’s largest bank holding companies, for already (with punishments attached), and in investment banks—rather than allow- many regional banks that surpass the 2014 they chose to reject the living ing Bear Stearns to file for bankruptcy $50 billion asset threshold are strug- wills of 11 banks with assets greater 12 in early 2008. This mistake shaped the gling with compliance requirements than $250 billion. If this were an subsequent actions of regulators, as designed to apply equally to global instance of clear cut non-compliance, well as the way that another invest- behemoths, but it is highly arbitrary the regulations would be working ment bank, Lehman Brothers, chose for other SIFIs, as well, since the effectively. But the priorities and to operate (and not seek to sell itself ) FSOC faces few real constraints on considerations of regulators in evalu- 11 before its own failure later that year. which institutions to designate. ating these living wills are opaque The partnership between the govern- Title I reveals the problem with and not connected to any formal, ment and the biggest banks resembles corporatism most starkly. SIFIs are public legal framework. Such cloudy the European style of regulation subject to stricter regulations, includ- regulatory intervention gives banks a known as corporatism, which is far ing more stringent capital standards, strong incentive to be non-transpar- removed from the rule of law virtues but the largest SIFIs also have special ent themselves about their operations, traditionally associated with U.S. relationships with their regulators contrary to the intended spirit of 10 financial regulation. who, through the law, protect them Dodd-Frank.

NOTES

ing wills in 2014. The Fed felt that single point of entry would 2013. For more on that bill, see: http://dealbook.nytimes. not work without a stay on derivatives globally. The living com/2013/05/01/in-brown-vitter-bill-a-banking-overhaul- will reprimands resulted in a new International Swaps and with-possible-teeth/?_r=0. Derivatives Association (ISDA) protocol that mandates just that – a global one day stay. Every major bank has agreed to abide by the terms of the ISDA protcol. 16 Dodd-Frank gives the Fed authority to rescue a failing clearinghouse. 17 A similar policy was recommended in a bill sponsored by Senators Sherod Brown (D-OH) and David Vitter (R-LA) in

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The third concern involves the FDIC’s stated intention to utilize OBSERVATIONS AND POLICY Orderly Liquidation Authority under the so-called “single point of entry” RECOMMENDATIONS FOR Title II, which was created to give strategy in the case of a future failure IMPROVING DODD-FRANK regulators, in this case the Treasury, to recapitalize SIFIs seems to be in the Fed, and the FDIC, the authority direct conflict with the language of One area of reform that Dodd-Frank 13 to take over a financial institution fac- Title II. How this will play out in largely got right concerns derivatives. ing an impending failure which could practice bears watching. The derivatives regulations in the result in systemic harm. Regulators The final rule of law issue involves law have been encouraging thus far, can trigger a takeover resolution by the Volcker Rule. As noted above, this especially the creation of clearing- submitting a petition in federal court rule attempts to achieve a 21st century houses for over-the-counter trading, with extremely limited judicial review version of the Glass-Steagall Act’s the increased disclosure requirements, (24 hours). The speed and secrecy (the separation of commercial and invest- and the establishment of a one day 15 hearing itself is unannounced) of the ment banking by prohibiting bank stay on derivatives. The majority of decision essentially prevents compa- holding companies from engaging in interest rate swaps and credit default nies from challenging a takeover. This proprietary trading and by limiting to swaps now are being cleared over the process is likely unconstitutional, as 3% of total assets their investments exchanges, although foreign exchange it appears to violate the due process in hedge funds and equity funds. This and commodities derivatives did requirements of the U.S. Constitu- is a quixotic quest because it is nearly escape the new regulations. By requir- tion, although it would be difficult in impossible to distinguish proprietary ing clearing, Dodd-Frank substitutes practice for a SIFI to challenge the trading from normal market-making one type of too big to fail institution violation before its takeover occurred. and client-based trading. Over time, for another (yet another unintended For the moment, regulators thus even the line between investment consequence), but this is likely an have largely unchecked discretion and commercial banking within bank improvement from the pre-crisis envi- over whether and when to take over holding companies likely will blur, ronment because regulators should be a financial institution on the verge and the five different regulators able to better manage a failing clear- of default, as well as how to resolve charged with enforcing the Volcker inghouse than they would a large bank the situation once the SIFI goes Rule will not be able to sufficiently with its complicated organizational 16 into receivership. As in the case of monitor trading in the world’s largest structure. an ordinary bank resolution, Title II financial institutions. Given Dodd-Frank’s unintended grants the FDIC blanket authority Beyond the clear and already pres- consequences and departures from to pay claims to creditors in full if it ent failures and inefficiencies of the the rule of law, how might the legisla- wishes, and it also allows for estab- Volcker Rule, the costs of compliance tion be improved? Here are several lished priority payment rules to be and implementation have skyrock- recommendations. abandoned for the sake of systemic eted to $4.3 billion and $413 million, Recommendation 1: Restore the stability. Interestingly, despite the fact respectively. The burden falls dispro- rule of law by reducing regulator dis- that Title II requires that its resolu- portionately on smaller community cretion. One obvious corrective might tion provisions be used to liquidate and regional banks that don’t have be to require greater transparency and troubled SIFIs and not to reorganize legal resources comparable to the clearer rules for Title I’s designation 14 them, the FDIC has been explor- biggest banks. This causes an eco- and living will processes. ing a strategy for resolving SIFI nomic drag when smaller banks are Recommendation 2: Relatedly, issues (i.e., reorganizing) over the last unable to make loans to small and policymakers should give banks an few years. Senator Barbara Boxer’s mid-sized businesses at the level they incentive to downsize efficiently, (D-CA) “thou shalt liquidate” man- might in the absence of these vast as opposed to creating a blanket date may be the clearest directive of compliance challenges. prohibition on proprietary trading. the entire Dodd-Frank Act, but the This would help to ensure that these

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institutions do not also retreat from handful of bankruptcy reforms that ease regulatory burdens on banks market-making and client services, would better facilitate a financial and credit unions with less than $10 which hurts system-wide liquidity, institution bankruptcy. The most billion in assets, as these institutions and that less activity gets pushed important change involves imposing would no longer need to abide by into the shadow banking system, a stay, or a standstill, on derivatives the Volcker Rule. which already is occurring because counterparties when a SIFI declares of the Volcker Rule. One solution bankruptcy. The derivatives industry CONCLUSION might be onerous capital require- managed to get an exemption from ments on banks above a certain the normal bankruptcy rules, which The Dodd-Frank Act sought to limit asset level (e.g., $500 billion), which mandate that collections be stopped risk in the financial system before a would let banks decide for them- immediately, contracts cannot be SIFI failure or crisis (and thus limit 17 selves how to shed businesses. terminated, and collateral cannot be the amount of activity flowing into Recommendation 3: Policy- sold. In the last five years, there has the shadow banking system) by reg- makers should be mindful of activity been movement around this issue to ulating key instruments, like deriva- outside the traditional financial help SIFIs on the verge of default by tives, and institutions, like banks and system and curb the incentives to enacting bankruptcy reform similar insurance companies. The law also shift key operations to the shadow to the single point of entry strategy. sought to limit damage in the event banking system. This could include Legislation on this issue, which of any systemically important finan- shadow banking regulations or new would include derivatives, is pending cial institution’s failure. Although SIFI regulations focused on risk in Congress. the objectives and some of the level rather than capital level, type Recommendation 5: Off-ramps new regulations are admirable, the of activity, or entity. Any regulations for small banks that are dispro- legislation attempts to accomplish based on risk and not on entity type portionately burdened by the SIFI its dual mandate through corporatist would require collapsing regulators designation process’s size limits regulations that stray from tradi- (e.g., SEC and CFTC), and while and CFPB regulations would be tional U.S. rule of law virtues, and there is little to no appetite for beneficial. A bill sponsored by it has spawned a series of negative, that in Washington, reforms that Senator Richard Shelby (R-AL), for unintended consequences. But the point in this direction are worth instance, would authorize regulators law can be corrected and improved. serious consideration. to subject banks between $50 billion Dodd-Frank still has the potential Recommendation 4: To further and $500 billion in assets to Title I to help safeguard the financial sys- reduce regulators’ incentive to bail oversight, but would make inclusion tem if some of its obvious kinks are out large troubled financial institu- automatic only at the $500 billion worked out. tions, lawmakers should adopt a level. The Shelby bill would further

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ABOUT THE AUTHOR DAVID ARTHUR SKEEL, JD Professor of Corporate Law, Penn Law School

David Skeel is the S. Samuel Arsht Professor of Corporate Law at the University of Pennsylvania’s School of Law. He is the author of The New Financial Deal: Understanding the Dodd-Frank Act and Its (Unintended) Consequences (Wiley, 2011), Icarus in the Boardroom (Oxford, 2005) and Debt’s Dominion: A History of Bankruptcy Law in America (Princeton, 2001), as well as numer- ous articles and other publications. He has been interviewed on The News Hour, Nightline, Chris Matthews’ Hardball (MS- NBC), National Public Radio, and Marketplace, among others, and has been quoted in the New York Times, Wall Street Jour- nal, Washington Post and other newspapers and magazines. Skeel has received the Harvey Levin award three times for outstanding teaching, as selected by a vote of the graduating class, the Robert A. Gorman award for excellence in upper level course teaching, and the University’s Lindback Award for distinguished teaching. In addition to bankruptcy and corporate law, Skeel also writes on sovereign debt, Christianity and law, and poetry and the law, and is an elder at Tenth Presbyterian Church in Philadelphia.

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